Portfolio Diversification Redux: Think Like a Trader

Long term investors know better than to put all their eggs in one basket. Option traders, on the other hand, tend to break eggs. If you don’t break more than you keep, you come out ahead. That’s the idea, anyway.

Eggs and baskets are just a simple way of saying don’t load up on too many stocks from one sector in case said sector should collapse. This, as you know, is the most basic tenet of diversification.

As an option trader, you’re likely trading momentum stocks that you track or that pop up on your daily scans. There’s probably not a lot of sector diversification going on because you’re thinking less about a company’s balance sheet or future earnings potential versus what a price chart tells you about tomorrow’s action on a given stock. For shorter-term option traders, the lens of diversification focuses on price, time, and volatility (vol).

Is Hedging the New Diversification?

Diversification is typically characterized as a strategy designed to reduce your overall risk. But it’s really meant to smooth out the gains when things go right. You could be diversified with bullish investments across a spectrum of stocks, sectors, or even indices. But if the market drops, you could still lose, because most stocks tend to correlate when the market crashes.

This is called “systematic risk”—the risk that the whole market, or at least the sector you’re invested in, could move against you. For option traders, it’s not enough to diversify across different sectors, especially when you’re trading options that feature other risks besides the directional (price) risk of stocks. Now, this doesn’t mean you forego diversification altogether. But for option traders, hedging should be an integral part of your trading plan because on one hand, you have the systematic price risk of the market and, on the other, you have the risks of time decay and changes to implied volatility (IV).

So, what’s the difference between diversification and hedging? In short, diversification is sharing the love and spreading your investments across different stock sectors or asset groups (like stocks, bonds, and cash). Hedging is taking an “offsetting” trade in hopes of reducing risk—basically putting on another trade in the opposite direction. When hedging with options, price, time, and vol are usually top of mind.

Hedge Like a Pro

Because market makers (who typically take the other side of your trade) hedge every trade, let’s start by taking a peek at their playbook. Let’s go through a typical market-maker hedging progression using the May 135 call option in figure 1 as an example.

If a market maker buys the May 135 call option at the bid price of $5 (they buy at the bid where you, the retail trader, are selling), they need to address three main risks: price (delta), time decay (theta), and changes to IV (vega). These are the same risks the retail option trader needs to manage.

Typically when you buy an option, a market maker on the other side of the trade sells it to you and turns around and buys it back from someone else for a perfect hedge, while pocketing the spread between the bid and ask. When that doesn’t work, they’ll rely on synthetic relationships between options to construct their hedges, such as creating “synthetic stock” to offset the risk. (See “Level Up Your Options Knowledge: Synthetics and Beyond” in thinkMoney 52.)

If you understand synthetics, you know the market maker could sell the 135 call synthetically through a combination of selling the 135 put and selling the stock. This would hedge the trifecta of main risks but could also expose the position to early exercise, dividend risk, and pin risk.

An alternative hedging opportunity would be to sell another May call option with a strike as close to 135 as possible, such as a 140 or 130 call. The trade would become either a short or long vertical spread depending on the strike. The further away this trade is from the 135 strike, the less risk reduction it’s likely to provide.

Selling another 135 call in a different, shorter-term expiration would turn the trade into a calendar spread and likely reduce the delta risk, theta risk, and vega risk. In fact, any additional trade that reduces any of these risks can be considered a hedge. Yet, keep in mind, you’re not looking to completely eliminate risk because without it you likely won’t make any money.

How do you apply all this to your real-world options trades?

Price

It’s tempting to fill your portfolio with bullish trades when the market is going up. But even if you’re “diversified” across different sectors, you’ll likely lose money if the market drops. Even in a bull market, not all stocks move up at the same time. When a stock does move up, it might rest and retrace some of the time, or it may trade sideways as it consolidates its gains. The same is true when the market is going down, so you can consider layering in some bullish trades as part of an overall bearish strategy.

You can also reduce directional risk by turning existing long call or long put positions into long verticals by adding a short option at a further strike. You’ll still have your directional trade on but with less risk. Before adding another long call to a portfolio that already has long calls in other stocks, see if those other positions might be ripe for this type of hedge.

Time decay

Turning long options into long verticals hedges your directional risk and pares down your time decay (and vol) risk. You can also reduce your overall time decay risk before you put on the trade by buying more time than you need.

Buying “more” time might sound like the opposite of hedging, but longer-term options don’t decay as quickly as shorter-term counterparts. Over a given time frame, you’ll likely give up less money to time decay with longer-term options. If you expect to be in a trade for 30 days, you’ll cut your time decay by buying options that expire in 60 or 90 days.

Volatility

If your trades tend to be long options strategies or have longer time horizons, you’re probably going to be long vega as well. Calendar spreads, for example, are vega-positive trades that can suffer when IV drops. But you don’t have to ignore this strategy when vol is high. You might consider a butterfly spread. This risk profile has positive theta similar to the calendar, but it comes with short vega rather than the calendar’s long vega risk.

Worth Remembering

From a directional standpoint, if you’re bullish (or bearish), starting with a long vertical spread rather than a straight long option is a strategy designed to weather a vol crush—that is, when IV drops in an instant, such as after earnings announcements or other expected news releases.

Another risk to watch is the market’s overall vol. The IV of one option may not correlate with the IV of another. But if the Cboe Volatility Index (VIX) is high, then IVs across the board will mostly likely also be high, and this may not be the time to load up on long vega trades. Conversely, if the VIX is low, you might avoid being short a bunch of iron condors.

Of course, what’s high and what’s low can be subject to debate. For a long time, a VIX at 20 was considered high, and it would bottom out around 11 or 12. Sometimes highs have been around 30 to 40 with occasional spikes even higher, with 20 at the low end. But in 2021, we saw that low cracking and giving way to a VIX in the high teens. Is the “normal” range shifting again? Anything is possible (see “How to Spot a New Volatility Regime”).

Overall, diversification is an important tool, but it’s just one of many at your disposal. When markets sell off, assets tend to correlate and diversification becomes less effective. When you hedge, you engage offsetting trades that can augment diversification and can also be risk-reduction tools.